It still ain't easy being green - for a REIT A discussion of selected tax developments and considerations - Deloitte Center for Energy Solutions
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It still ain’t easy being green – for a REIT A discussion of selected tax developments and considerations Deloitte Center for Energy Solutions
Numerous federal incentives have been enacted to accelerate capital investment in renewable energy and conservation
technologies including the production tax credit, the investment tax credit, bonus depreciation, Internal Revenue Code
(IRC) Section 179D expense deductions, and cash grants. The “greening” trend continues to accelerate, as many states
have adopted a variety of renewable portfolio standards which require or promote minimum thresholds of power
generation from renewable sources. Several states have also adopted renewable energy certificate (REC) programs
creating an open market for certificates that can be traded among multiple parties. The purchaser of a REC can claim
the benefits associated with producing energy from renewable sources. The seller obtains a source of revenue which can
provide financing for these capital-intensive projects.
In our previous publication, The Changing Environment of R&R (REITs and Renewables)1, we addressed the difficulties
real estate investment trusts (REITs) encounter in taking advantage of the emerging framework of tax incentives seeking
to stimulate investment in renewable energy. We explored why their unique tax status and applicable regulatory regime,
prevented REITs from being able to utilize these incentives in the same manner as non-REIT commercial property owners,
thus placing them at a significant market disadvantage.
As owners of millions of square feet of commercial real estate, REITs could potentially be significant consumers of energy
from renewable sources. Furthermore, they may also be a significant source of capital for renewable energy development.
In this point of view, we will return to the analysis in our prior publication of the interplay between REITs and energy-
related incentives and then explore the emerging and evolving landscape of REIT requirements and these valuable energy
incentives. We will use solar renewables as a focal point for the discussion to explore the use of REITs as a vehicle to
finance capital investment into renewables while leveraging the REITs’ status as an entity with a single level of tax and an
increasingly popular form of investment, both public and private.
Federal investment tax credit and cash grants
A taxpayer purchasing qualifying energy property may receive a credit against their federal income tax liability of
between 10 percent and 30 percent, depending on the type of qualifying investment. Qualifying investments include
renewable energy investments, such as solar and small wind property, if placed in service before 2017.2 For a REIT, these
credits continue to be of limited use as, in general, a REIT only incurs a federal income tax liability to the extent it fails to
distribute all of its taxable income.
The IRC Section 1603 cash grant program3 was enacted to provide an alternative subsidy for investment in renewables.
This program provides a reimbursement to eligible applicants for a portion of the cost of qualifying property equal to
30 percent of its investment in certain renewable energy properties.4 In general, in order to qualify under this program,
construction of the qualifying solar property must have begun before 2011 and must be placed in service before 2017.5
As with tax credits, however, a REIT is only able to obtain a grant to the extent it incurs a federal tax liability due to its
failure to distribute all its taxable income.
1
http://www.deloitte.com/assets/Dcom-UnitedStates/Local%20Assets/Documents/FSI/us_re_changingenviroment%20of%20RR_280910.pdf
2
Placed in service date requirements are specific and vary by type of renewable energy property. Solar and small wind or other IRC Section 48
property must be placed in service before 2017 to receive a 30 percent tax credit. IRC Section 45 property must be placed in service before
2013 in the case of wind property and before 2014 for biomass and other qualifying property.
3
Enacted as part of the American Recovery and Reinvestment Act of 2009.
4
While the IRC Section 1603 Cash Grant program was in place, cash grants could be received in lieu of the investment tax credit.
5
The cash grant program has placed in service date requirements that conform to the incentive tax credit, with a “safe harbor” for a
minimum amount of construction to have begun before the end of 2011.
2Federal IRC Section 179D
IRC Section 179D provides a good example of the complexity of the tax issues related to installing energy-efficient
systems. A commercial building owner can claim a deduction equal to $1.80 per square foot for energy-efficient
property placed in service between January 1, 2006, and December 31, 2013, for property located in the United States.
Certification requirements must be met in order to qualify for the deduction. For this purpose, energy-efficient property
includes interior lighting systems, heating, cooling, ventilation, hot water systems, or the building envelope, but solar
panels do not qualify within the definition of energy-efficient property, thereby causing a certain amount of confusion.
IRC Section 179D also illustrates some of the tax issues specifically affecting REITs embarking on sustainable energy
programs. REIT dividend levels are often set to market requirements as opposed to simply managing taxable income.
Accordingly, the deduction may not be a significant incentive to a REIT that must maintain a certain dividend level. In
addition, an important nuance may cancel the benefit of the deduction for the REIT’s shareholders. A distribution from a
REIT is treated as a dividend to the extent of its “earnings and profits,” but the deduction under IRC Section 179D does
not reduce earnings and profits, and as a consequence, the shareholders do not receive the benefit of the deduction since
the amount of the distribution treated as a dividend is not reduced.
Legislative changes may be necessary for REITs to benefit from federal incentives
Industry groups have supported numerous proposals seeking to modify the existing incentive regimes to benefit REITs.
Some examples of these proposals include:
• Designing a credit useable to a REIT, such as providing a credit against capital gains or allowing the REIT to pass the
credit through to tenants
• Creating a refundable energy tax credit that is not reduced even if the REIT makes mandatory distributions
(i.e., distributions equal to taxable income)
• Providing clarification that the right to receive a cash grant or energy tax credit qualifies as a real estate asset
for REIT testing purposes6
• Fixing the conformity issue between taxable income and earnings and profits (highlighted above in the discussion
of IRC Section 179D) to allow shareholders to benefit from the deduction
Emerging revenue-generating programs and associated REIT implications
In The Changing Environment of R&R, we examined the broad emergence of direct incentive payments or renewable
portfolio standards designed to encourage investment in the generation of renewable energy. Revenue streams obtained
from the receipt of direct incentive payments or from the sale of renewable energy certificates provide economic support
in addition to the federal tax credits. These performance-based incentives (PBIs) are generally received when renewable
energy enters the grid, but can be sold and purchased separately from the power.
6
In order to qualify as a REIT, an entity must satisfy various income and asset tests. Among these tests, at least 75 percent of the value of a
REIT's total assets must consist of “real estate assets”, cash and cash items, and government securities at the end of each calendar quarter.
There is no direct guidance as to how the right to receive grants or credits would be treated in this computation.
It still ain’t easy being green – for a REIT 3The Internal Revenue Service (IRS) has not provided guidance on the REIT tax treatment of income from PBIs. As there is no
direct authority to treat this income as qualified REIT income, some have concluded it is non-qualifying or “bad income.”7 But
given the breadth of these programs at the federal and state levels and the potential role of real estate owners in leveraging
billions of square feet of real estate (e.g., roof and/or land) to generate energy, it is important to analyze this further to
determine the level of support for treating PBIs as qualifying income and energy property as real estate.
Citing the legislative history underlying the tax treatment of REITs, the IRS has indicated Congress’ concern in enacting this
requirement was to prevent a REIT from engaging in the active conduct of a trade or business. In certain cases, the IRS has
concluded the transactions were not inconsistent with the purpose of the REIT requirements and therefore, income from
the transactions could be disregarded in determining whether the REIT satisfied the income tests. For example, in separate
private letter rulings (PLR), the IRS concluded income derived from refundable state tax credits for the remediation and
development of contaminated real estate would not be considered in determining whether the taxpayer satisfied the REIT
income tests and that the right to receive the credit payment should be disregarded in determining whether the taxpayer
had met the asset test (PLR 200614024, 200916014 and 200528004). Although PBIs are incentives separate from those
delivered through current tax regimes, the analysis of their impact on REIT qualification should be the same, at least to the
extent the energy system is related primarily to the real estate and its tenants.
Treasury authority to treat income as qualifying or excludable
In 2008, Congress specifically granted the Treasury general authority to determine what type of income would be treated
as qualifying income or to exclude the income entirely for purposes of REIT testing. Given the growth in numbers of
credits and incentives in the area of renewable energy, including credit exchanges, the Treasury could potentially exercise
its discretion to permit REITs and their shareholders to benefit from these incentives.
Structural approaches to date
Historically REITs have been owners of commercial real estate, such as office buildings, warehouses, or multifamily housing
properties. In recent years, there has been significant discussion surrounding whether a REIT, with its access to public
capital, and a single level of taxation, might provide the solution to the next wave of low-cost financing needed to broadly
encourage investment in solar electricity. In The Changing Environment of R&R, we provided two possible approaches,
both of which remain viable today, to a REITs investment in solar panels. These are shown on the following page.
7
In addition to other requirements imposed for REIT qualification, REITS must also satisfy two gross income tests annually, a “95% test” and
a “75% test”. At least 75 percent of its gross income must be derived from certain sources including rents from real property, interest on real
property mortgages, gains on dispositions of real property not held for sale to customers in the ordinary course of business, and certain other
specified sources. At least 95 percent of its gross income must be derived from these sources or from non-real estate dividends and interest and
certain other specified sources. Accordingly, no more than five percent of a REIT’s gross income may be derived from sources other than those
described above. This five percent is commonly referred to as a REIT’s “bad income bucket”.
4Scenario 1 – Third-party owner of solar panels
REIT
Lease of
rooftop space
Third-party Pricing of rooftop lease would
Lease
(Solar Panel consider economic benefits derived
owner and by Third-party owner/operator of
operator) solar panel
Tenant Agreement to provide
energy to REIT
Scenario 2 – The taxable REIT subsidiary (TRS) owner
REIT
TRS Lease of • Transfer pricing considerations
rooftop space in pricing lease and energy
• Possible benefits to TRS
Agreement to through credits/incentives/
provide grants
Lease energy to REIT TRS
• Management contained and
(Solar Panel
controlled by REIT
owner and
operator) • Compliance with related party
rent rules and "limited rental
Tenant exception" is assumed but
would require monitoring
It still ain’t easy being green – for a REIT 5Renewable energy property as “real property”
One of the challenges presented with respect to incorporating renewable energy projects into a REIT structure is whether
the renewable energy infrastructure may qualify as “real estate assets” for REIT purposes. Section 1.856-3(d) of the
Treasury regulations defines real property as “land or improvements thereon, such as buildings” or “other inherently
permanent structures” not “accessory to the operation of a business.” There has been significant case law and PLRs
interpreting the latter phrase. In General Counsel Memorandum 33996, the IRS concluded property is accessory to the
operation of a business if it is in the nature of machinery or equipment, regardless of how actively or passively it functions.
In reaching this conclusion, the IRS relied on language from IRC Section 179, which contains the definition of tangible
personal property. The application of this reasoning with respect to passive machinery or equipment could lead to the
conclusion that renewable energy production property, such as wiring, modules, and mounting structure on solar plants,
should be excluded from the definition of real property.
The IRS, however, has excluded certain types of machinery or equipment from the category of “asset accessory to the
operation of a business” and classified those types of properties as “real property” for REIT purposes. For example, in
Revenue Rule 73-424, the IRS concluded a permanently installed total energy system that provided for production of all
the electricity, steam, hot water, or refrigeration for the building was an inherently permanent structure even though
the system contained items of machinery and equipment such as turbine-driven generators. In a separate PLR, the IRS
concluded the physical space on a building rooftop, together with the right to use the space, qualified as real estate
property. In addition, billboards and signs attached to the roofs or walls are also considered real estate assets for REIT
qualification purposes.
Recent development
The IRS has continued the trend of expanding the definition of real property for REIT purposes. In PLR 201323016
(July 30, 2012), the IRS ruled the taxpayer’s interests in certain structural improvements constituted “real estate assets”
for purposes of REIT requirements and ruled the taxpayer’s interest income from the financing of structural improvements
qualified as interest on obligations secured by mortgages on real property or interests in real property, thus satisfying the
“income test” for a REIT. The “structural improvements” to which the ruling relates included a photovoltaic array located
on the roof of, or adjacent to, the building. It is important to note the structural improvements were used solely in energy
production for the use of the building or facility and were considered by the IRS to constitute structural components of
the building. This ruling falls short of classifying the solar panels as real estate in the context of a business selling electricity
to third parties. The extent to which renewable energy infrastructure will qualify as real property is still an open question
and subject to review and scrutiny by the IRS.
Will REITs ever be green?
Even in an environment rife with limitations, the greening of REITs continues, from traditional rooftop leases, to financing
renewables in transactions secured by real estate, to purchasing and leasing the land underneath solar projects. It remains
to be seen whether three years from now we are writing again to list the challenges facing a REIT seeking to invest in
renewables or to applaud a wave of significant investment into renewables.
6It still ain’t easy being green – for a REIT 7
Learn More If you would like to discuss this paper in more detail, please contact: Author: Jessica Duran Partner, Business Tax Services Deloitte Tax LLP + 1 415 783 5968 jeduran@deloitte.com Additional contacts: Marlene Motyka Charles Temkin U.S. Alternative Energy Leader Director, Passthroughs Group Deloitte Financial Advisory Services LLP Deloitte Tax LLP +1 973 602 5691 +1 202 879 4970 mmotyka@deloitte.com ctemkin@deloitte.com Gary Hecimovich Larry Varellas Partner, Washington National Tax Partner, Real Estate Federal Tax Accounting Methods, Periods & Credits Deloitte Tax LLP Deloitte Tax LLP +1 415 783 6637 +1 202 879 4936 lvarellas@deloitte.com ghecimovich@deloitte.com Thomas Stevens Partner, Business Tax Services Deloitte Tax LLP +1 619 237 6785 tstevens@deloitte.com About the Deloitte Center for Energy Solutions The Deloitte Center for Energy Solutions provides a forum for innovation, thought leadership, groundbreaking research, and industry collaboration to help companies solve the most complex energy challenges. Through the Center, Deloitte’s Energy & Resources Group leads the debate on critical topics on the minds of executives—from the impact of legislative and regulatory policy, to operational efficiency, to sustainable and profitable growth. We provide comprehensive solutions through a global network of specialists and thought leaders. With locations in Houston and Washington, D.C., the Deloitte Center for Energy Solutions offers interaction through seminars, roundtables and other forms of engagement, where established and growing companies can come together to learn, discuss and debate. www.deloitte.com/energysolutions This publication contains general information only and is based on the experiences and research of Deloitte practitioners. Deloitte is not, by means of this publication, rendering business, financial, investment, or other professional advice or services. This publication is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. Deloitte, its affiliates, and related entities shall not be responsible for any loss sustained by any person who relies on this publication. About Deloitte Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee, and its network of member firms, each of which is a legally separate and independent entity. Please see www.deloitte.com/about for a detailed description of the legal structure of Deloitte Touche Tohmatsu Limited and its member firms. Please see www. deloitte.com/us/about for a detailed description of the legal structure of Deloitte LLP and its subsidiaries. Certain services may not be available to attest clients under the rules and regulations of public accounting. Copyright © 2013 Deloitte Development LLC, All rights reserved Member for Deloitte Touche Tohmatsu Limited
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